merged

A common good is

A common good is nonexcludable. Nonpayers cannot easily be excluded from consuming the good. Example 15: Fishing in Lake Springfield has never been subject to restrictions. The lake has never been popular for fishing. People complain that the fish taste funny. So there has never been a reason to incur the cost of placing limitations on how many fish any one person can catch from the lake. There were never so many fish removed from the lake to significantly affect the fish population. Because a common good is nonexcludable, consumers will tend to overconsume the good. Example 16: Due to the publicity it receives from a popular television show, the Monty has become a valuable fish. Aquariums will pay hundreds of dollars for each one. Unfortunately, Montys are unable to reproduce in any environment other than Lake Springfield. Something in the water. Ideally, the Monty would be fished out of Lake Springfield no faster than it can reproduce and sustain its population. If Lake Springfield were privately owned, its owner would be motivated to avoid overfishing. But since the lake is a common good, each person who fishes the lake will be motivated to catch all the Montys that they can before someone else catches them all. The Monty will be fished to extinction. The tendency to overconsume common goods is called the “tragedy of the commons”. Historical examples include the hunting to extinction of the passenger pigeon (which was once the most common bird in North America) and the hunting to near-extinction of the American Bison. Other examples include traffic congestion, overfishing the oceans, overcrowded National Parks, and environmental degradation. The tragedy of the commons can be analyzed as an externality problem. Each person who consumes a common good is receiving a private benefit and generating both a private cost and an external cost (the reduction of the amount of the common good available for others to consume). As long as the marginal private benefit exceeds the marginal private cost, the person will continue to consume. Example 17: As long as the benefit to Homer of catching one more Monty from Lake Springfield exceeds the cost to Homer, he will continue to catch more Montys. He will ignore the external cost that he is imposing on others. The tragedy of the commons can also be analyzed as a type of prisoners’ dilemma. Example 18: All of the people fishing for Montys in Lake Springfield would benefit if they could agree to limit their catch in order to sustain the Montys in the lake. However, each person’s dominant strategy is to catch as many Montys as possible, whether other people stick to the agreement or break it. One way to solve the tragedy of the commons is to turn the common good into a privately owned good. Example 19: If Lake Springfield were privately owned, its owner would be motivated to avoid overfishing in order to sustain the population of Montys. Example 20: According to the USDA, about 35 million cattle are slaughtered in the U.S. each year. Yet there is no concern that cows will become extinct. Another way to solve the tragedy of the commons is by government regulation or taxation to prevent overconsumption. FOR REVIEW ONLY - NOT FOR DISTRIBUTION 27 - 9 Market Failure

Example 21: The city of Springfield can place a limitation on the number of Montys that can be fished out of Lake Springfield each year. The most economically efficient approach would be to auction off Monty fishing licenses to the high bidder. That would ensure that the limited supply of Montys would go to the user with the most valuable use. Asymmetric Information Another source of market failure is asymmetric information. One party to an exchange may have information that the other party doesn’t have. Asymmetric information may result in a market producing more or less than the optimal quantity. Example 22: Fifty years ago, tobacco companies knew a lot more about the dangers of cigarette smoking than the average cigarette smoker knew. Asymmetric information may result in adverse selection. When adverse selection occurs, the party lacking information will be confronted by a different selection than expected. Example 23A: If an auto insurance company charges “one rate” for all drivers, the company may expect a normal selection of drivers to apply for a policy. But the actual selection will consist mainly of “high risk” drivers. Example 23B: Under the Affordable Care Act, insurance providers may not deny coverage or charge higher premiums based on pre-existing conditions. If there were no individual mandate requiring most individuals to purchase health insurance, a person could wait until they developed a health problem before purchasing health insurance. A person could not be denied coverage or charged higher premiums based on this pre-existing condition. Individuals in good health would have no incentive to purchase health insurance, since they could always purchase the health insurance that they need after they develop a health problem. Thus, only those with health problems would purchase health insurance. This adverse selection of purchasers would mean that health insurance premiums would have to be very high. Asymmetric information may result in moral hazard. Moral hazard occurs when one party to an exchange changes his or her behavior after the exchange in a way unexpected by and detrimental to the other party. Example 24: After drivers acquire an auto insurance policy, their driving habits may deteriorate since their personal risk of loss from an auto accident is reduced. Economists disagree on how severe a problem is created by asymmetric information. Some economists see asymmetric information as a major flaw in the market system and believe that the less informed party (usually the consumer) suffers large losses as a result. Other economists argue that information is usually available, though at a cost. They assert that the decision as to how much information to acquire is best left to the consumer. Example 25: Barney is in the market for a used car. Barney is a big guy and often suffers from alcohol-induced clumsiness, so he is looking for a car that is roomy and easy to climb into and out of. Moe owns a used car that is roomy and easy to climb into and out of. Moe knows a lot about the car’s history for reliability. Barney does not. This asymmetric information may cause Barney to buy a car that he would not want or to agree to pay a price that is more than he would be willing to pay if he were better informed. However, Barney has the option of acquiring more information. He can take the car to a trusted mechanic to have it checked out. He can research the reliability of cars of the same make and model. He can pay for a service that will give him a history of the car. Barney will decide how much cost he is willing to incur to increase the information he has about the car. FOR REVIEW ONLY - NOT FOR DISTRIBUTION Market Failure 27 - 10